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Wednesday, December 10, 2008

The Importance of the Fed's Balance Sheet

The Fed's balance sheet has blown up from about $900 billion in August 2007 to almost $2.2 trillion in early December, 2008. This means the monetary base--which is comprised of the liability side of the Fed's balance sheet--has also blown up. Normally, such a development would boost spending and create inflationary pressures, but not this time. The Fed has cleverly employed two strategies to "sterilize" the impact on aggregate demand from the growth of its balance sheet:(1) pay interest on excess reserves and (2) have the U.S. Treasury conduct quasi-open market operations for the Fed (i.e. the Treasury supplemental financing program where the Treasury is selling securities and parking the payments at the Fed.) Both of these operations have allowed the Fed to inject massive amounts of liquidity to the troubled parts of the financial system while keeping the pressures from the liquidity contained.

There are some big problems, though, with this strategy. First, as John Berry notes, the Fed will have to reverse all these actions once the financial crisis ends. The timing of this reversal will be key: move too soon and risk further economic fallout, move too late and watch inflation emerge. Second, the Fed's ability to reverse its liquidity injections has been compromised since its Treasury holdings have fallen almost in half. The decline in the Fed's Treasury holdings is the result of the Fed swapping its Treasuries for illiquid assets in the hope that these actions would kick start distressed asset markets. But if this strategy does not work, the Fed will be in the position of having fewer assets than liabilities. As a result, the Fed's ability to tighten would be limited.

Is there any hope for the Fed's balance sheet? Apparently, the Fed thinks there is at least one more clever solution: issue its own debt. As reported by the WSJ, the Fed is considering debt sales of its own. This would certainly give it more flexibility in managing its balance sheet, but it comes with a whole set of new problems as noted by Yves Smith and Jesse. Chris Sims has been thinking about these problems. He has a paper that outlines the some of issues. Here are some excerpts:

Should the central bank care about its balance sheet?

Naive answer: Of course not, since they can always “print money” to pay for anything they owe.

Correct answer: Yes, if the central bank is responsible for controlling inflation.

If the CB’s stock of assets is well below the total value of its liabilities, there will be limits to how sharply it can tighten without running out of assets to sell.

Some CB’s in this situation (running out of assets) have issued interest bearing debt on their own account (e.g. Korea) or taken in deposits bearing market interest rates (Israel). These have non-traditional fiscal impacts — in effect an unelected body is generating potential future fiscal burdens and competing with the Treasury in the bond markets.

[...]Rosy scenario[for the Fed going forward]

The panic subsides.

The private assets the Fed and the Treasury have acquired prove saleable at prices better than their purchase prices.

The tax burden of future generations is slightly reduced.

The Fed goes back to its old balance sheet model; independence of monetary policy is preserved.

Bad luck: Deflationary spiral[for the Fed going forward]

Even the tremendous interventions of the Fed and the Treasury prove too slow and too small to stem panic.

Asset prices continue to drop.

Bankruptcies snowball.

Commodity price drops feed in to the general price level and deflation accelerates.

Deflation only makes bonds still more attractive.

Deflation makes Fed dollar-denominated assets rise in real value, while making more of the private loans it has acquired default — the Fed’s balance sheet deteriorates.

Bad luck: Inflationary spiral[for the Fed going forward]

The Fed’s asset purchases turn out to be worth little.

Possibly even without deflation, its balance sheet goes negative.

Popular revulsion against Wall Street and the Fed makes it politically impossible for the Treasury to provide backing to the Fed.

No new taxes” political rhetoric becomes even more popular, so that investors come to see the US as unlikely to back its suddenly larger fiscal burden with future primary surpluses.

So inflation spirals out of control

Bad luck: Good policy[for the Fed going forward]

That either or both of inflation and deflation could emerge if the assets acquired turn out to be worth little is both a frightening aspect of the situation and a key to its possible resolution.

Several recent studies analyzing the great depression (e.g. Eggertsson, AER) have suggested that the only successful monetary/fiscal policy combination would have been one that convinced the public that policy would deliver future inflation at some target level.

This would make government paper less attractive now, and thereby induce people to start spending.

Read the rest of the paper here. Until this crisis, I did not realize the composition of a central bank's balance sheet could be so important.

Update: Tyler Cowen weighs in on the Fed's proposal to issue its own debt.